5 Facts the Finance Industry Would Rather Ignore

With the House and Senate at work on differing proposals for financial reform, real change in the financial system seems more elusive than ever. Rebounding bank profits, a direct result of government giveaways, and gobbledygook from the industry have successfully fogged the issue. The vast public is in danger of losing sight of what was once, for a brief moment, plain as day: the financial system in its current form is ill-designed and unstable. Here are five essential facts the financial industry would rather be ignored.

Investment banking was the specific source of the problem. The so-called financial "tsunami" was entirely man-made. The problem arose directly and specifically from widespread abuses of trust involving inordinate risks taken with other people's money. Investment banking in its pure form is the arrangement of risky deals for third parties to participate in. Like real estate agents, investment bankers collect fees on completed deals. Those fees increase with the size of the deal, and with its risk. The problem arose when individuals charged with prudently managing other people's money began to imitate investment bankers seeking ever bigger, ever riskier deals with the associated high fees. The problem multiplied as investment bankers, through their marketing efforts and through institutional ties, gained access to huge pools of capital in our financial system to exploit for their own purposes. Never again should government funds, our own money, be used to subsidize irresponsible risk taking for the benefit of dealmakers. Nor should commercial banks, so essential to the modern economy, be conflated with investment banking schemes.

Investment bankers were given a second chance. And not just any second chance. Instead of punishment for obvious transgressions, they've been rewarded beyond their dreams. So far the Federal Government has provided nearly 3 trillion to bail out the financial sector and promised a further 8 trillion if necessary. Investment bankers were big beneficiaries. Some benefits were direct, for example the government backed rescue of Bear Stearns, the government guarantee in the Merrill Lynch/Bank of America deal, TARP funding to financial firms, and widespread access to free money at the Fed's discount window. Others were indirect, such as the bailout of AIG from debts that it couldn't pay to Goldman Sachs among other lenders.

Investment bankers are now even more thoroughly integrated into the system. During the panic, investment banks were either bought by commercial banks -- Bear Stearns bought by JP Morgan, Merrill Lynch bought by Bank of America, Lehman absorbed by Barclays -- or magically converted into commercial banks like Goldman Sachs and Morgan Stanley. This has several effects. First, institutions, like Merrill or Bear Stearns that were deemed too big to fail are now even bigger, effectively guaranteeing that no matter what they do the public will be on the hook. Second, investment bankers now have access to even more money to use for their risky deals. And finally, through investor insurance and similar guarantees the public fisc is explicitly committed to some of these risky activities.

Incomplete reform won't work. Major proposals, including those now being worked on by both House and Senate committees as well as the White House proposals fail to comprehensively tackle the root cause of the crisis -- bankers making huge profits by taking inappropriate risks with other people's money. The most useful part of these proposals is to mandate higher capital requirements on large and interconnected firms. That's a step in the right direction. But commercial banks already had very strict capital requirements, yet that didn't stop Citibank and Bank of America from getting into trouble. Any loopholes, whether via derivatives or newer financial schemes, will provide an end run around stricter capital requirements. Without rethinking risk across the board higher capital requirements won't be very effective.

Policymakers confused cause and effect. The government's economists rightly recognized that banks are strong when the economy is strong. But they foolishly sought to strengthen the economy by strengthening banks. In fact for every dollar spent to stimulate the non-financial economy, three times that amount has gone into the financial system. The functions of banking are essential for the economy to prosper. But specific banks when bankrupt should be sold and reopened under new management. After committing nearly one year's total national economic output, the government has helped Goldman Sachs have one of its most profitable years ever while legions of firms and individuals deemed small enough to fail, fail.

The purpose of comprehensive financial reform isn't to limit bankers' wealth or to prevent yesterday's specific problems. It's about strengthening the financial system. Reducing systemic risk will benefit the whole economy, and in the long run the banks themselves.